Decisions you make today can subject you to more inflation tomorrow! Read below about ways to increase or decrease your exposure to inflation tomorrow.
Tax Planning
As a practical matter, most Americans have the majority of their retirement savings in traditional, pre-tax vehicles such as the 401(k). Having money in a traditional 401(k) is not a bad thing. However, the traditional 401(k) involves trade offs: an upfront tax deduction is the primary benefit in exchange for future taxation when there is a withdrawal or Roth conversion.
Having money inside traditional retirement accounts subjects future inflation to taxation. Some of the future growth in a traditional retirement account is likely to be attributable to inflation, and thus there will be a tax on inflation. Further, there are no inflation adjustments when it comes to the taxation of traditional IRA and traditional 401(k) withdrawals.
An antidote to this problem is the tax free growth offered by Roth accounts and health savings accounts. Getting money into Roths and HSAs excuses future growth from taxation, including growth attributable to inflation.
Roth 401(k) versus Roth IRA
Of course, inflation is only one consideration. Many will do some traditional retirement account contributions and some Roth retirement account contributions. The question then arises: which Roth account to use?
My view is that for many a Roth IRA contribution (whether a direct annual contribution or a Backdoor Roth IRA) is better than a Roth 401(k) contribution. Many do not qualify to deduct a traditional IRA contribution but can deduct a traditional 401(k) contribution. Considering that reality, why not combine a deductible traditional 401(k) contribution and a Roth IRA contribution?
Long Term Fixed Rate Debt
Often we discuss how inflation hurts Americans, and we should be concerned about the bad effects of inflation. However, there is a way to become a beneficiary of inflation: using long-term, low interest fixed rate debt to your advantage.
That’s right: hold onto that low rate 30 year mortgage like it’s a life raft! Okay, that’s a bit hyperbolic, but the overall point holds. Inflationary environments are great for debtors, particularly those debtors who have locked in a low interest rate for a long term.
Here is an example: Sarah and Mike have a 30 year, $400,000 mortgage on their primary residence at a 2.9% fixed interest rate. By paying the required monthly payment, and no more, they benefit from any future inflation. By paying off the mortgage later rather than sooner, they are using devalued future money to pay the mortgage rather than more valuable current day dollars.
Sarah and Mike benefit from inflation! Are there reasons to pay off a mortgage early? Sure. But in an inflationary environment, paying off the mortgage early gives the bank more valuable dollars to satisfy the debt.
To my mind, a fixed rate, long term mortgage is a great hedge against inflation.
That said, there are few perfect financial planning tactics. Most involve risk trade offs. One risk Sarah and Mike assume by not paying down the mortgage early is the risk of deflation. To obtain this inflation hedge, they expose themselves to the risk of deflation. If the U.S. dollar starts to deflate (i.e., it appreciates in value), Sarah and Mike will find themselves paying more valuable dollars to the bank in the future.
Travel Rewards
Travel rewards can help fight inflation. One way is using sign-up bonuses and other accrued points to pay for hotel room nights or flights. Using points gets out of cash paying and thus inflation of the dollar hurts a bit less.
However, keep in mind that travel reward points are subject to their own inflation! The hotel chain or airline can devalue the redemption value of points at any time. Thus, if everything else is equal, those with significant travel rewards point balances might want to spend those points sooner rather than later for travel.
A second consideration are the features of credit cards. Some travel branded credit cards come with certificates for free nights or a companion pass for a companion to receive free or discounted flights. If flighting inflation is a key goal, favoring cards that offer free-night certificates or companion passes can be a way to fight inflation.
Spending that Leads to More or Less Future Spending
We’re used to assessing the price tag. $28,000 for that brand new car: “that’s a great deal!” or “that’s a terrible deal!” But the price tag is only one part of the financial picture.
If you buy a black cup of coffee at Starbucks, it might cost you $2.65. Fortunately, that’s it. The cup of coffee isn’t likely to cause you to incur later costs.
What about a $45,000 SUV? That purchase will cause later costs, many significant. For example, the cost to insure a $45,000 SUV might be significantly more than insuring a $22,000 sedan. What about gas? By purchasing a larger, less fuel-efficient car, you lock in more future spending, and thus more exposure to future inflation.
Think about buying a large home with a pool in the backyard. That square footage attracts property tax, heating and cooling costs, and inflation in both costs. The pool in the backyard requires constant upkeep, subjecting the homeowner to another source of inflation.
To my mind, food is a big one in the fight against inflation. What you eat today could very well translate into medical costs tomorrow, exposing you to significant inflation. Spending on foods with vegetable oils and sugars today is likely to increase your future exposure to medical expense inflation.
The lesson is this: you can use today’s spending to reduce your exposure to future inflation.
Conclusion
Is there a perfect answer to inflation? No. But with some intentional planning and spending today, Americans can reduce their exposure to the harmful effects of future inflation.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
What is the math behind Roth being better than Traditional?
Tax brackets also increase with inflation, so outside of other factors, does it really matter?
Wise Finish, thank you for reading and commenting, I appreciate it.
From an inflation only perspective, I firmly believe Roth is the way to go. You are correct – there are inflation adjustments in the tax rules. However, the adjustments mostly impact things such as tax rate. Having assets subject to tax (in a traditional IRA) exposes the growth attributable to inflation to taxation. Inflation adjustments don’t cure the problem. Roth is great from that perspective. Having assets in a Roth means never worrying about tax on growth, which is fantastic.
Inflation, of course, is only one issue to consider in financial planning. Whether traditional contributions or Roth contributions are better very much depends on the particular circumstances of each particular person. I believe (i) there is no boiler plate answer in the traditional vs. Roth discussion, (ii) the decision can be impactful in terms of each individual reaching their financial goals, and (iii) the Roth vs. traditional analysis necessarily involves a degree of uncertainty as future tax rates can change based on a variety of factors.
Thanks for sharing this!